Question

What are the 3 major instruments that central banks can use to control money supply? Explain each one.

Answer 1

Three major instruments used by the central bank to control money supply are- open market operations, reserve requirement and discount rate.

Open market operations

Open market operation is one of the quantitative instruments of monetary policy. Open market operations deal with the sale and purchase of short term and long term government securities in the open market. In the open market, central bank sale and purchase the securities to and from the commercial banks. Government securities include treasury notes, bills, government bonds and mortgage backed securities. The major objective of open market operation is to control the supply of money by selling and purchasing of government securities. central bank deals with the commercial banks for the sale and purchase of government securities rather than with public. Open market instruments are way to bring yield over the government securities and to control the supply of money. It is helpful to control the inflation and deflation in economy.

Function of open market operations during inflation

The reason for inflation in an economy is rise in liquidity with the public. There is need to check the inflation to improve the currency value and to attain the economic growth. During inflation central bank , sale the government securities to commercial banks to reduce their deposit reserves. It also decreases the prices of government securities, equaling to increase in interest rate. The major objective of central bank during inflation is to reduce the money supply by increasing the interest rates. The result is that public makes payment by withdrawing the money deposits from the commercial banks and these reduce the commercial banks activity of credit creation. It reduces the money supply and inflation is curbed.

Function of open market operations during deflation

The reason for deflation in an economy is fall in liquidity with the public. There is need to check the deflation to improve the currency value and to attain the economic growth. During deflation central bank , purchase the government securities from commercial banks to increase their deposit reserves. It also increases the prices of government securities, equaling to decrease in interest rate. The major objective of central bank during deflation is to increase the money supply by decreasing the interest rates, and these increase the commercial banks activity of credit creation. It increases the money supply and deflation is curbed.

2 Cash reserve ratio-

Cash reserve ratio is decided by the central bank monetary policy committee in the periodic monetary and credit policy. It is an important tool in thecentral bank hand with, it tries to curb the excess inflation by checking money supply and by making changes in the reserves with commercial banks. Commercial banks have deposits of the public through they create credit in the economy. Therefore, it becomes essential to control over the credit creation by the commercial banks.

Function of cash reserve ratio during inflation

The reason for inflation in an economy is rise in liquidity with the public due to high reserves with commercial banks through commercial banks create credit. There is need to check the inflation to improve the currency value and to attain the economic growth. During inflation central bank , increases the cash reserve ratio and in this way, commercial banks have less credit to increase the money supply.

Function of cash reserve ratio during deflation

The reason for deflation in an economy is fall in liquidity with the public. There is need to check the deflation to improve the currency value and to attain the economic growth. During deflation central bank , decreases the cash reserve ratio and in this way, commercial banks have enough credit to increase the money supply. The major objective of central bank during deflation is to increase the money supply by decreasing the cash reserve ratio. The result is that public can have more borrowings from the commercial banks at cheap interest rate due to high liquidity with commercial banks.

Discount rate.

It is rate which is decided by the central bank . Bank rate is an important tool to control the money supply in an economy by having impact over the money supply in an economy. Bank rate is he rate at which central bank lends money to the banking system .

Function of bank rate during inflation

The reason of high inflation in economy is the high liquidity with the commercial banks.

It is essential to control over the inflation to improve the economic growth of nation. Therefore, central bank makes changes in bank rate to control the money supply. During inflation, central bank increases the bank rate. With increase in bank rate it becomes costly for the commercial banks to borrow from the central bank.

Function of bank rate during deflation

The reason of high deflation in economy is the less liquidity with the commercial banks.

It is essential to control over the deflation to improve the economic growth of nation. Therefore, central bank makes changes in bank rate to control the money supply. During deflation, central bank  decreases the bank rate. With decrease in bank rate, it becomes cheaper for the commercial banks to borrow from the central bank. Bank rate is like an interest rate that commercial banks have to pay to central bank. With decrease in bank rate, commercial banks have to give less interest rate to central bank and therefore, they have more money with themselves to create credit and therefore, increase the money supply and in this way, deflation is controlled by the central bank .